Quant ideas: Liquidity in commodity risk management

Limited liquidity is a problem that arises frequently when managing large assets, such as power plants or storage facilities. Krzysztof Wolyniec shows how standard financial models tend to overstate the cashflows of these facilities and explains how simple quantitative adjustments can make them more effective

Liquidity plays a vastly underappreciated role in commodity markets. Often, a lack of liquidity is treated as an analytical inconvenience to be patched up, so that the standard analytical and valuation tools can be still used. This practice arises from the standard procedures in financial markets, where the price paid for simplification is typically not a large one, unless we find ourselves in a crisis situation when liquidity simply disappears. The traumatic experience of the credit crisis